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In Cyprus deal, Russia may have the last laugh

Europe won this round. But Russia may have the last laugh.

As part of a $13 billion deal to a bail out a pair of bloated Cyprus banks, European officials Monday won the Nicosia government’s backing for a painful “haircut” on bank accounts that will inflict maximum financial pain on Russian companies and wealthy depositors who have long used the tiny island nation as a tax shelter.

The last-minute deal, reached just hours before a European ultimatum to cut off the country’s financial lifelines, is aimed at reining in a Cypriot banking system that had gorged on tax-dodging oligarchs and failed Greek bonds.

The agreement ends a week of street protests in Cyprus, long lines at withdrawal-limited cash machines, and a tense geopolitical standoff after European officials made the unprecedented demand that ordinary Cypriot savers share in the cost of any bank bailout.

Under the final terms, accounts of under $130,000 will be spared. But the concession will shift the financial pain even more heavily to large accounts, many of which hold roughly $30 billion in assets belonging to Russian companies and wealthy individuals. Under the revised terms, large account holders now stand to lose as much of 40 percent of their money – four times the original proposal.

Russian leaders – who last week rejected pleas from Cypriot officials for an alternative financial lifeline – were understandable unhappy with the final deal.

"The stealing of what has already been stolen continues," Prime Minister Dmitry Medvedev reportedly told a private meeting of government officials.

In their public response, Russian officials have been more measured. The government signaled Monday it would help backstop the European bailout by refinancing a 2011 loan with a lower interest rate or by extending repayment deadlines.

Despite widespread anger over a plan widely denounced in Moscow as “bank robbery,” the Russians have reason to soften their public stance.

For one thing, Moscow and Nicosia still enjoy deep economic and political ties that go well beyond the latest tug-of-war with Europe. Cyprus represents an important strategic location in the Mediterranean, even more so as the future of Russian ally Syria grows more uncertain.

Russian energy companies are also eyeing large, recently discovered deposits of natural gas in Cyprus.

"It's a mistake to think that it's a very special class of rich people [that have their money in Cyprus]," said Cyprus' finance minister, Michael Sarris, early Monday. "Russians have their lawyers, accountants or their families and friends in Cyprus, so our relationship can withstand a shock like this."

While the European bank bailout will be painful for individual haircut victims, the overall losses are relatively small – less than 1 percent of total deposits in the Russian banking system.

By stepping back from the turmoil, Russia can now watch European leaders struggle with what promises to become an even bigger money pit. Having helped break the banking system in Cyprus, Europe now owns it.

It’s not clear how much more cash will be needed to finish the job. As part of the bailout, Cyprus’ second largest bank, Laiki , was sold for parts to the Bank of Cyprus, the country’s largest. Laiki’s toxic assets will be sold off over time – assuming any one wants them.

The financial hole in Cypriot banks may yet deepen further as skittish depositors head for the exits once they eventually are allowed to get their hands on their money. Confiscating large chunk of existing accounts will make new depositors think twice about handing their money over to a Cypriot bank.

On Monday, there was still no official timetable for ending an ongoing bank “holiday.” Bailout terms also include yet-unspecified restrictions on future withdrawals.

By standing on the sidelines, Russia has also left European leaders with an even bigger mess to clean up. Though the Brussels bailout may succeed in shrinking bloated Cypriot financial system, it will trash the Cypriot economy, which relies heavily on its banking sector for jobs and tax revenues.

After busting Cyprus' banks, European officials acknowledged that the tiny nation - with an economy smaller than Vermont's - now faces a painful recession that will require an even bigger Brussels bailout in fairly short order.

“The near future will be very difficult for the country and its people and the (European) Commission will do everything possible to alleviate the social consequences of this economic shock,” Europe's Commissioner for Economic Affairs, Olli Rehn, told reporters after the deal was announced.

European leaders face even bigger headaches beyond tiny Sypruis. Their new “bail-in” strategy - forcing bank depositors to pay for a bail-out - hasn’t gone unnoticed in much larger countries, like Italy and Spain, with much larger banks and economies. Despite those two countries’ limited trade and finance links to Cyprus, the wider bailout backlash could create a much bigger mess for Europe

The worry is that depositors in those banking systems – which are far too large for Europe to backstop – could stage a slow-motion bank run to move their cash out of the reach of Brussels bureaucrats. Bank stocks in Italy and Spain were down sharply Monday.

Beyond the financial impact, the political backlash to the Cypriot bailout may be even more damaging to the long-run prospects of a unified Europe.

For the past two years, resentment has been growing in struggling southern countries like Greece, Spain, Italy – and now Cyrus – over harsh economic demands from their wealthy northern neighbors – lead by Germany.

Recent elections have only widened that political divide. In Italy, for example, voters recently rejected Brussels-friendly candidates in favor of an anti-euro, comic-turned-politician, Beppe Grillo, and former prime minister, Silvo Berlusconi, a colorful media tycoon convicted of tax evasion.

The result is that Italy has yet to form a new government with the legal authority to negotiate with European leaders.

“We’re talking about the third biggest euro zone economy - basically a political system currently frozen because of this huge populist movement,” said Jim O’Neill, chairman of Goldman Sachs Asset Management. “They seem to be saying, ‘We have had enough.’” That is not an easy thing to solve at all.”